Tuesday, 22 July 2014

Economists crash but don’t burn

Economists have been
caught up in their own tale of hubris but have come out barely unscathed

Sometimes life plays out like fiction and such has been the
case with economists. The advocates of
economics had been riding high at the beginning of the century as everything seemed
to be running smoothly. Economists look
on a renewed sense of swagger stemming from the (mistaken) belief that fluctuations
in the economy had been mastered. But as
often happens in a tale of hubris, the world comes crashing down just at the
point where the hero starts to get carried away. Such has been the tragedy for economists but
it is the rest of us that have paid the price.

Set for a fall

Like the rest of us, economists are liable to go too far
when things go their way. This is made
worse by the way in which economics can be seen as more like a religion than a science as it
is difficult to prove that economic ideas are wrong. This means that faith can mean more than
fact. But when faith and fact align is
when the problems really begin. Such was
the case for a couple of decades after economists increasingly took charge of
central banks since the 1980s.

Central banks took on the mission of combating the scourge
of inflation and their success with this began to build up confidence in their
capabilities. Their theories led
economists to believe that low and stable inflation was the key to economic
wealth and well-being. But this meant
that problems were allowed to fester elsewhere in the economy due to this narrow focus on consumer prices. The dot com bubble just
over ten years ago should have been a wakeup call. Prices for tech stock had gotten out of hand
but central banks preferred to stand back with the plan of letting the boom and
bust run its course and then mop up afterwards.
The mild recession that followed reaffirmed the notion that central banks
could fix any problems.

No so clever after
all

Economists made the most of their time in the sun. Thinking that they had all of the answers,
economists started applying their ideas to other topics. Economists also increasingly plugged their
ideas to the public fuelled by the claim that economics could explain almost
everything (see the photo above). Thinking
that they knew it all, economists weren’t afraid to let other know about
it. As is typical for a Greek tragedy,
it is precisely at this point (where the hero thinks that the world has been conquered)
that everything comes crashing down.

The turning point in this tale of woe came with the global
financial crisis. Economists were not
just unfortunate victims of unforeseen circumstance but were the architects of their
own downfall. Their conviction in their
own ideas prompted economists at central banks to overlook growing distortions
in the economy. Interest rates were kept too low for too long
which allowed for the levels of debt to get out of hand. The dogma of the almighty central bank also led
to complacency at banks that chased after profits without worrying about risks in the economy.

Skipping over the lesson
of the tale

It does not take the wisdom of hindsight to see that catastrophe
was just around the corner. But it does
help with realizing that the success that central banks achieved may have been
more due to luck than clever management.
The surge in exports from China was always going to keep prices down
whatever central banks did. Inflation may not even be a major concern any more considering that prices did not jump despite the
surge in lending heading into the global financial crisis or with central banks
printing loads of cash as part of quantitative easing.

The saga proved to be something similar to the tale of
Icarus. Emboldened economists also flew
too close to the sun but it was their ideas that went into eventually went into
meltdown. But the main difference is
that, while economists have fallen from grace, it was others who got badly
burnt. This would be easier to take if
economists were busying themselves coming up with better ideas to allow for
less turbulence in the economy. But economists are slow learners
and policy is still guided by the same old ideas. Change may happen and hopefully it does
before we all crash and burn again.

Two big levers by using the infinite cash producing facility and one dubious lever that tries to set the expectations several years down the line.

We are slowly being crucified on the Bernanke principle of "(asset price) deflation will not happen here". Yes the bond prices are at an all time high, the stock markets similarly, achieved through forcing institutions into searching for return on capital. House prices in the UK are similarly not being allowed to settle at an historically affordable level.

The QE influx was never going to put cash in the hands of the people. It was done to prevent the banks failing due to their balance sheets suffering if their assets collapsed in value.

Now we are seven odd years down the line and the central banks do not dare to raise interest rates. The bonds would collapse, the stock market would collapse and the indebted populations will suffer.

It is a big mess.

They have meddled too much and now nobody on the planet can achieve any income, so the money is swirling into pushing asset prices higher and higher.